In this article we explore last month’s Budget announcement that for corporation tax purposes there is to be a removal of capital gains indexation allowance from 1 January 2018.

Key points

• The change will impact some (not all) gains arising in UK life funds
• Indexation will not disappear suddenly, but instead gradually tail off
• Onshore bond funds will continue to pay tax at an effective rate less than 20%
• Indexation allowance is just one element which drives down the effective rate below 20%
• There is no fundamental shift in the bonds & OEICs debate – both ‘wrappers’ offer competing attributes and will continue to co-exist

The announcement

“….when a company makes a capital gain on or after 1 January 2018, the indexation allowance that is applied in order to determine the amount of the chargeable gain will be calculated up to December 2017.

Without this measure, indexation allowance would be calculated up to the month in which the disposal of the asset occurs.”

What does this mean?

This change will impact certain gains arising in UK life funds since insurance companies have a mechanism where they collect from policyholder funds, the tax calculated on behalf of the policyholder at life company level. Broadly, there is an alignment between the tax recovered from policyholders to the taxation of the fund itself as part of the I-E computation.

Life fund taxation is highly complex but the gist of the change is as follows.

Currently, when a UK life fund realises a capital gain then some gains are taxable at 20% but other gains are reduced by indexation allowance before being taxed at 20%. For example, a gain on disposal of shares in an ‘interest’ fund would attract no indexation, but a gain on disposal of shares in an equity fund would attract indexation.

Essentially, indexation allowance strips out the inflationary aspect of the gain and is calculated using monthly RPI figures. Therefore, in time of low inflation, indexation will correspondingly be low.

This methodology simply derives from the fact that companies in general are entitled to indexation allowance to reduce some capital gains which are subject to corporation tax. Life funds are subject to corporation tax and therefore the budget change will have an impact on UK life funds.

In short, indexation allowance ensures that the effective rate of tax on gains which attract indexation will be less than 20%.

What reason was given for the change?

The Budget measure aligns the treatment of corporate capital gains with those realised by individuals. Essentially indexation allowance is a bit of an anomaly in the sense that neither individuals nor unincorporated businesses have been able to claim indexation allowance since 2008. In addition the Government stated that the change will simplify tax computations and remove a source of potential errors.

How will the change be implemented?

When a company (including an insurance fund) makes a capital gain on or after 1 January 2018, the indexation allowance that is applied will be calculated only up to December 2017. In other words, as time passes, indexation allowance will gradually tail off.

What does it mean for onshore bonds?

The fund overall will continue to pay tax at an effective rate less than 20%.

Indexation allowance is just one element which drives down the effective rate below 20%. The impact is also dependent on economic conditions i.e. inflation over the period invested and asset mix of the fund.

Return is made up of many components

In particular, remember that UK & overseas dividends are exempt from tax – clearly this exemption also drives down the effective rate. The effective rate will be higher than before but still less than 20%. Despite the effective rate being less than 20%, investors in UK insurance bond are treated as having paid tax at 20%. This is why gains on UK bonds are not liable to basic rate tax.

Many assets will have significant dividends paid but little or no capital growth so indexation relief is not such a benefit and the tax benefit is being driven by the sheltering of the dividends from personal taxation.

It remains the case that individuals, trustees & corporates all effectively enjoy a tax credit of 20% despite the fact the fund overall suffers tax at a rate less than 20%.

Are offshore bonds affected?

Offshore life funds enjoy ‘gross roll up’, and are not therefore affected by these changes as they pay no tax on gains within the fund. The investor, of course, does not effectively enjoy a 20% tax credit.

Are Open Ended Investment Companies (OEIC) affected?

An OEIC fund is not subject to tax on capital gains and instead the gain is taxed at investor level. If the gain is realised by an individual or by trustees then there is no indexation allowance available to reduce the taxable gain. No change therefore.

Note however that a company with surplus cash might purchase OEICs. In that case, the investing company is entitled to indexation allowance on the disposal of equity funds to reduce the gain subject to corporation tax. The change will therefore impact on that situation. .

Do the changes fundamentally shift the Bonds & OEICs debate?

No. Remember that from a tax perspective, bonds & OEICs are at the opposite ends of the investment spectrum. Broadly OEICs must distribute net income by way of dividends or interest but bonds are non-income producing. These competing attributes will continue to offer planning options for clients.

The same bond opportunities will still exist (don’t forget incidentally that the dividend ‘allowance’ is being cut for 2018/19 by 60% to just £2,000). For example…

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